Clear Eyed Capitalist

Archive for May, 2007

From vcexperts.com: “Wash-Out Round: A financing round whereby previous investors, the founders, and management suffer significant dilution. Usually as a result of a washout round, the new investor gains majority ownership and control of the company. Also known as burn-out or cram-down rounds.”

At the CDVCA conference in DC in March, a VC made the ear-catching comment that “Angels get crammed down because they overpay.” After watching several Bay Area Angels grit their teeth as they referenced dot-com era cramdowns in the Kauffman seminar I took last year, this was definitely the other side of the coin. I definitely believe there are abuses on both sides of the investor-entrepreneur relationship, so it was interesting to be thinking about the Angel/VC relationship.

Do Angels overpay? A mentor suggested to me early on that the first round is the worst round, it’s the last round that gets the best deal. That runs counter to expectations, but makes sense if the company lives out a story like: 1) entrepreneurs, out of optimism or desperation to attract investor attention, set ambitious projections. 2) when you don’t meet your projections, you can find yourself in difficult financial straits, thus giving leverage to your next negotiating partner. 3) if you’re not making your projections, you’re not worth the valuation that took them into account. Thus, a down round.

However initial valuation is derived, it becomes a key point when negotiating the next round. According to a 2005 survey done by Tony Stanco and Uto Akah at The George Washington University [about 5 miles from my childhood home –sm] “The number one reason for making angel portfolio companies unattractive to VCs is the fact that angels tend to give start-ups overly high, unrealistic valuations.” (p 11.) according to this survey, VCs think angels need more work on valuation skills. This seems to be the case in the social enterprise markets as well. Cathy Clark and Selen Ucak write in their report on the market experience of Social Entrepreneurs that some feel like the funding markets are not rational. “Potential investors do not know how to evaluate our market or viability.”

So why not? I think its in part because Angels are at a serious resource disadvantage. As single investors without back offices we don’t have access to deal databases and can only read so many PE newsletters. In my observation, particularly since most exits these days seem to be via acquisition, estimating a value means knowing the current M&A market. The only way an Angel can be that informed is to hug close to a single industry, ideally the industry they made their money in and theoretically have an information advantage from their experience. Another key factor in valuation is simply negotiating leverage. If you’re a VC and can offer to fund ¾ of their current raise, you have much more leverage than a group of angels suggesting they’ll band together to cover 1/4, which is much more of the world I see outside the core VC money centers. A single VC is also much better positioned to apply that leverage as a focused negotiating party, as opposed to angel groups worried about fiduciary responsibility and being very hands-off in helping angel investors organize. To be thorough, we could also accuse Angels of not thinking too hard about future funding rounds. In order to do multiple rounds of funding with any kind of markup and end up at a valuation that’s realistic on the last round, that first round has got to be pretty low. We can put that blame on the entrepreneur as well.

However, surf any number of VC blogs and deal-pricing is inevitably referred to as an art. Let’s face it, we’re trying to predict the future value of something in the face of a great deal of risk – this is all about risk capital, right? In my mind, its all about negotiation, and if Angels are getting regularly crammed down to support VC profits that says as much to me about relative leverage as relative smarts. That said, I’m way more wary about high valuation. This is also changing in the world of SOX – the feds are getting more stringent about how assets are marked to market value and this may drive more standards in valuation and use of professional appraisers– but primarily in the professionalized VC leagues. The amateur angel leagues are still likely to wing it, which leaves us vulnerable to cram-down between our lower negotiating leverage and our less well priced first round, which I will contend is part of the higher risk of the early stage.

What to do? The National Association of Seed and Venture Funds (NASVF ) recommends doing convertible debt rounds for early rounds. That helps postpone the valuation negotiation until a later round when there will a) be more information and b) you’ll be side-by-side with those bigger, more experienced institutional players and get their same valuation. The next question with this route is how those seed round investors get compensated for their early risk. One common strategy is to convert into the next round at some discount to the round: IE if it’s $1/share you buy in at 85 cents. Or you accrue interest at some rate that allows the discount for the next round to adjust based on how long it takes. Or you get warrants of common stock for investing in the debt round. Does that help? Some. I’m seeing many deals go through more than one round of all-angel, so we build up a bigger pile of low-leverage, poorly organized investors before we get to the big guns.

Net, I do think companies frequently come to Angels with excessively high valuations, and Angels in the capital hinterlands are less well-equipped to negotiate those down. We need to develop more experience with valuation and perhaps appraisers, and figure out how to better negotiate as groups, and after the dot-com boom and bust hopefully we’re in an evolutionary stage where VCs and Angels are learning to play better together.

My burning question about wind is: if climate change can impact the weather so much, and change the life-sustaining ocean conveyor belt, then can’t it affect wind patterns? so what’s the point of doing 1-3 years of wind studies to site a turbine farm if the wind might change?

I posed this question to a fellow student at the last BGI intensive, and he suggested that what shapes the wind is the ground shape, and that’s not likely to change. So I finally did a little websurfing.

I found a blog (I can’t tell who they are, but they’re really into renewable energy.) talking about how wind energy is really another version of solar energy (wait… familiar.. that was in our book!)

“All the mountains, oceans, valleys and whatnot effect the way the wind goes, but for the most part these large scale patterns develop and stay pretty consistent. You have to remember that wind patterns are driven by the difference in temperature between different parts of the earth, the temperature difference between the surface of the earth and space, and the turning of the earth. It can get complicated fast. ” ok, we’re validating my friend’s thinking…

“So how does global warming figure into this? Global warming is causing a lot of the parts of the earth to get warmer. The poles are warming very fast, as are the oceans. So that means that places that used to be cold are now getting hot. So in some cases global warming is making wind patterns weaker. Because the difference in temperature is less the wind will blow less.” Aha, so there is an effect. The blog goes on to talk about that impact on moisture distribution and how unpleasant that can be.

This NOAA site gets into how wind currents are created by the combination of high-pressure nodes, low-pressure nodes and the earth’s rotation. the high/low pressure areas are caused by humid air moving around (warming, rising, cooling, falling) which is again, something that is being changed by climate change, but this also seems like it would impact strength more than direction.

Last May an NOAA scientist named Gabriel Vecchi published a paper suggesting that global winds across the pacific have slowed 3.5% since the mid 1800s and will likely weaken another 10% by the end of this century.

Since the life expectancy of a wind-farm is far short of 100 years (more like 25), that’s not too concerning. So I guess that’s my conclusion: climate change (unchecked) *will* impact wind strength, if not patterns, but not within the lifetime of any windfarms we’re building now.

Yes, I’ve been non-posting, as an admirably prolific (and worth reading) friend prodded me today. Time to lower my standards and share some of the memes flying by.

Today I told a friend the story – as I have heard it retold – of how Muhummad Yunus started Grameen Bank. I’ve just started reading his book (Banker to the Poor), so from his pen I know that he was teaching economics when famine hit Bangladesh and he decided that he needed to ditch the fancy book learning and get out in the field to see what was really going on in the world. Presumably, in a chapter or two I’ll hit The Story. The retelling is that he goes into the village and observes a woman making stools from something like bamboo. He asks her how much she makes a day and it’s pennies. Turns out she has to borrow capital from the local moneylender to buy supplies, and he lends her the capital on the condition that she re-sell him the finished stools at a fixed price. A price which he sets, low and behold, and only pennies above her costs. Yunus asks her if she could make more selling the stools elsewhere and she says she can, but she’s trapped in this loop. He does a survey of the village and discovers he can free several folks from such bondage for less than $50, which he decides to just lend out of his own pocket. I would prefer to do my readers the service of verifying this is actually his story, but it’s close enough for the purpose of this post which is not so much about his story but my friend’s response, which was: “He’s lucky the moneylender didn’t break his leg!”

Not something that came up at the series of micro credit events I attended recently, but a pretty interesting commentary on the difference between doing business here and doing business in a little village. As civilized as we may like to think the U.S. is, an aggressive countermove from the competition would likely have snuffed such a budding enterprise here. I was immediately reminded of comments by friends in the biodiesel industry about how the collection of waste oil is aggressively competitive. Waste management contracts are apparently fairly lucrative and therefore highly defended which in some cases includes physical intimidation. Some newer waste oil collection companies have had problems with their cans being dumped and run-over and flattened.

At the much more common, legal level, my spouse and I a couple years got to observe one company essentially snuff another with a nuisance lawsuit. (I’m surprised I haven’t already told that story, but I don’t see it in my blog.) Sure the instigator lost eventually, but in the meantime they had used their superior financial resources to drain and distract the market leader while they caught up and innovated ahead. Since this was a situation where network effects kicked in, company 2 moved into number 1 and was able to strengthen that position. Once strong enough, they used their market power to put the squeeze on all the participating suppliers. As a supplier, we were frustrated, but pretty helpless because on the Internet it’s all about ability to draw traffic, you need those intermediaries who can act as congregation points. Money as Power is really a problem of capital markets – you need to aggregate capital so you have power so your capital (and thus your investors) can ensure favorable treatment and a better return, but not many folks make it to be big and still play nice. Seems like folks get burned so much on the way there that any intentions for good are gone. I have another blog on this topic that I’ve held back because it’s depressing, but I’ll post it this week.

On a related front of why we don’t get more socially responsible business here, I had the honor of meeting David Green at a recent BGI session. He’s an Ashoka Fellow and successful practitioner of “compassionate capitalism”. He helped establish a self-funded non-profit in India that does cataract surgery, revolutionized the supply chain for the needed lenses, and is now working on doing something similar with hearing aids. He commented that it would be difficult to set up such a company in the U.S. because non-profits quickly run into tax issues with unrelated business income, and if that doesn’t happen they’re likely to get sued for unfair competition by their for-profit counterparts. That’s assuming he could successfully grow the business on its own revenue. From other enterprises I’ve seen that the reason to start out as non-profit is because it is possible to get startup capital as grants. It’s when you have some revenue and need expansion capital that grants dry up.

The challenge of finding growth capital for successful earned-revenue social-service organizations is a topic discussed by Jed Emerson, Tim Freundlich and Jim Fruchterman in their paper “Nothing Ventured, Nothing Gained” about gaps in the capital markets for social enterprise. Tim has co-founded a company to try to address those gaps, called Good Capital that will work to fund socially-rewarding revenue-generating enterprise across for-profit and non-profit, while generating a return on capital. I will be working there this summer: mid-June to the end of September. I look forward to learning and sharing some more rays of hope.